3 Money Sucking Financial Innovations

August 13, 2010

Many fabulous financial innovations have been made in the last 15 years that have helped to make your life easier or better. Unfortunately, not all the financial innovations over that time have been positive; there have been some products and services created that can be a major drag on your net worth and even on your quality of life.

We’re obviously not fond of these money suckers, as you’ll read below, but we’ve never been in the situation where we’ve needed to tap into these “creative” sources of funding. If you’ve used any of these three, let us know why you needed to and your experiences with them in the comments at the end.

Payday Loans

Payday is a week and a half away. You have made financial mistakes in the past, and haven’t fully recovered from them.

Something happens — some financial emergency. Let’s say your refrigerator dies. You don’t have the funds to pay it, but it’s an issue that you have to resolve. (You’ve got to eat!)

You could use something like a credit card, but instead you choose to get an advance on your next paycheck. You figure that you’re working a steady job, you’ll be able to pay it back quickly enough. You get a loan for $400.

Bad idea.

These “lenders” use loopholes in state laws to get around maximum interest regulations. Your payday loan could cost you 100% to 500% depending on how deep in the trap you get caught. You write a check for the amount you are borrowing plus a fee. Let’s say you borrowed the $400 for the refrigerator and they charged you a $20 fee. You write a check for $420 to be cashed 10 days from now.

Even if you paid off the loan after 10 days you’ve paid $20 for 10 day loan on $400. That’s an annual percentage rate of 196%!

But what if you can’t pay the loan back? No worries, they’ll let you loan yourself the loan money for another 10 days, for the same fee. Now we’re up to $40 in fees for a $400 loan over 20 days.

The cycle starts there… if you can’t pay off the loan you start paying more and more in fees just to keep the loan active. Definitely a bad deal for consumers.

Interest-Only Mortgages

How does this scenario sound to you?

Mr. Banker is going to lend me several hundred thousand dollars for a home. I’m going to buy a home that I can’t afford a regular mortgage on. So Mr. Banker in all his infinite wisdom offers to let me pay only the interest on the loan. I never pay down any money on the principle of the home.

Sounds to me like you’ll be making payments the rest of your life!

Think about these scenarios that might lead you towards an interest-only loan:

You can’t afford a regular mortgage today, but some day your income will go up and you’ll be able to refinance into a standard 15 or 30-year mortgage that includes principle payments that will eventually lead to you owning the home.

You will never be able to afford the house, instead you rely on any gains from price appreciation from the price your purchased the house at.

Both of these could potentially result in you never putting a dime toward actually owning the home! Doesn’t sound like a good idea to me.

401(k) Loans

Your 401k plan at work gives you the opportunity to set aside pre-tax income for retirement. You get a tax break, your employer maybe offers you a match, and you build up a nest egg to live off some day in the future.

The fun doesn’t stop there. If you haven’t planned for the future well you can actually lend yourself some of that money. Got an emergency and no emergency fund on hand? Don’t worry — just raid your 401k!

This is a bad idea for multiple reasons:

The money you lend yourself could be earning a higher return in your 401k’s investment options. Instead you end up missing out on potential gains (and losses) in the portfolio.

You end up having to pay yourself interest.

If you lose your job you have to pay the funds back within 60 to 90 days (usually).

If you don’t pay back the loan the IRS considers it a taxable distribution and you’ll get nailed with a 10% fee plus federal income taxes. Ouch, ouch, and ouch.

Money Sucking Alternatives

So what’s the alternative to these money sucking options? An emergency fund is a good place to turn for fast cash, much better for your finances than a payday loan or a 401k loan. If a 401k loan isn’t for an emergency but rather some planned expense, it’s obviously better to save up in advance of the purchase.

In terms of interest only loans, a better alternative could be to rent until you’ve saved up enough money to buy the house you want. Or you could settle on a cheaper house for now and plan to by the more expensive house in the future.

Of course we know life doesn’t always go according to plan and not everyone has emergency funds or a savings account to tap into so if you’ve had an experience with one of these, let us know how it went in the comments below.

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Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He's building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, ING Direct, and many others.

Comments

8 Responses to 3 Money Sucking Financial Innovations

If you’re in the position where you’re thinking about a payday loan, you’re probably not reading Money Smart Life. (At least I hope not.)

I’m not sure which is worse – payday loans or interest-only mortgages. Never having been dumb enough to entertain the latter (or the former, for that matter), I’ve always wondered how the lender answers when the borrower says “We’re never going to pay this down, though, right?”

Fortunately, I take all the money I would’ve spent on payday loan interest and interest-only mortgage payments, and spend it on lottery tickets! My state government says that’s where dreams are born. They wouldn’t lie, right?

Payday loans really aren’t worth all the trouble, you end up paying way too much in interest just to keep your loans active. If your fridge dies and you have to wait one and a half weeks until the next pay day, try buying nonperishable food, fruit or using a cooler.

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